Income inequality

Lane Kenworthy, The Good SocietyJune 2016

Income inequality is inevitable. There is no practical way to ensure that everyone’s income is the same. It’s also necessary. We need financial incentives in order to encourage hard work, investment, and entrepreneurship.

Yet too much inequality is unfair. Much of what determines a person’s earnings and income — intelligence, creativity, physical and social skills, motivation, persistence, confidence, connections, inherited wealth, discrimination — is a product of genetics, parents’ assets and traits, and the quality of one’s childhood neighborhood and schools. These aren’t chosen; they are a matter of luck. A nontrivial portion of income inequality is therefore, arguably, undeserved.

Since the 1970s, income inequality in the United States has increased. How much? What’s caused this rise? Has it happened in other rich countries too? How has government responded? Has the increase in income inequality been offset by mobility? Has consumption inequality also risen? What do Americans think about income inequality?

INCOME INEQUALITY HAS INCREASED, ESPECIALLY AT THE TOP

Income inequality has risen sharply in recent decades. Its key feature has been a growing separation between the incomes of the top 1% and those of everyone else.1 This is displayed in figure 1. Average income in the top 1% tripled from 1979 to 2013, while incomes in the bottom 60% grew only modestly.

Figure 1. Average income of households in the top 1% and the bottom 60%Posttransfer-posttax income. The income measure includes earnings, capital gains, government transfers, other sources of cash income, in-kind income (employer-paid health insurance premiums, Medicare and Medicaid benefits, food stamps), employee contributions to 401(k) retirement plans, and employer-paid payroll taxes. Tax payments are subtracted. The incomes are in 2013 dollars; inflation adjustment is via the PCE. Data source: Congressional Budget Office, “The Distribution of Household Income and Federal Taxes, 2013,” Report 51361, 2016, supplemental data, worksheet 3.

HAS IT ALWAYS RISEN?

Figure 2 shows the top 1%’s share of pretax income going all the way back to 1913. (These data are from IRS tax records, and the federal income tax began in 1913.) During the middle of the 20th century, that share decreased slowly but persistently. It’s since the late 1970s that we observe a big jump in inequality.

Figure 2. Top 1%’s share of incomePretax income. Includes capital gains. Data source: World Wealth and Income Database.

HAS INCOME INEQUALITY INCREASED SHARPLY IN ALL RICH COUNTRIES?

Figure 3 shows the trends in the affluent nations for which we have data.2 (The appendix has a separate graph for each country.) The top 1%’s income share increased nearly as rapidly in Canada, Ireland, Korea, and the United Kingdom as in the US. It rose significantly but less rapidly in Australia, Finland, New Zealand, Norway, and Portugal. It increased only a little or not at all in Denmark, France, Germany, Italy, Japan, the Netherlands, Spain, Sweden, and Switzerland.

Tax cuts for the rich have contributed to the rise in income inequality in the US, but they aren’t the principal cause.

The top marginal federal income tax rate was reduced from 70% to 50% in 1981, and then to 28% in 1986. It was increased to 40% in the early 1990s, dropped to 35% in the early 2000s, and then raised to 40% again in 2013. But the effective federal tax rate on the top 1% — their federal taxes paid divided by their pretax income — decreased much less. If we compare business-cycle peak years, it was 35% in 1979, 28% in 1989, 33% in 2000, and 28% in 2007 (34% in 2013), according to calculations by the Congressional Budget Office.3

Figure 4 shows that these tax changes had a relatively small impact on the trend in income inequality. In 1979, the top 1%’s after-tax income share was about 83% as large as its pre-tax income share. In 2007, following the Reagan and Bush tax cuts, it had risen, but only to 89%. In 2013 it was back to 83%.

Figure 4. Top 1%’s income share before and after taxesIncludes capital gains. Federal taxes only; does not include state and local tax payments. Data source: Congressional Budget Office, “The Distribution of Household Income and Federal Taxes, 2013,” Report 51361, 2016, supplemental data, worksheet 3.

WHY THE SHARP RISE IN INEQUALITY OF MARKET INCOMES?

There is very little agreement among scientists about why inequality of pretransfer-pretax incomes has increased so much. Hypothesized culprits include:

More growth of demand than supply for highly-skilled labor and more growth of supply than demand for less-skilled workers

Increase in product market competition

Technological advance

Globalization

Shift from manufacturing to services

Union decline

Emergence of winner-take-all markets

More aggressive shareholders

Changes in CEO compensation practices: greater use of stock options, collusion among directors

Rising stock values

Deregulation of finance

Some of these contributed to slow earnings and income growth for those in the lower half, and others contributed to the concentration of income gains at the very top (as opposed to, say, the top half or quarter). In my view, each of these probably played a role. I doubt there were one or two or three that mattered a lot more than the others.4

According to analysis of tax records by Jon Bakija and colleagues, around two-thirds of the top 1%’s income, and much of the growth in its income, has gone to three groups: (1) executives, managers, supervisors, and entrepreneurs, (2) financial professions, including management, and (3) lawyers.5 The surge in stock prices from 1979 to 2007 contributed to soaring incomes for many executives and financiers and the lawyers who help them. Figure 5 shows the very strong correlation over time between the stock market and the top 1%’s share of income.

Figure 5. S&P 500 index and top 1%’s share of incomeStock values are adjusted for inflation, via the CPI-U-RS. Incomes are pretax, including capital gains. Data sources: Federal Reserve Bank of St. Louis, FRED Economic Data, series sp500; World Wealth and Income Database, series top 1% income share including capital gains.

WHAT ABOUT INCOME INEQUALITY AT THE BOTTOM?

Income inequality has increased not just between the top 1% and everyone else, but also between the middle class and the poor. A common measure of inequality in the lower half is the ratio of income at the 50th percentile (median) of the distribution to income at the 10th percentile. Figure 6 shows that lower-half income inequality in the US is higher now than in the late 1970s, though most of that increase occurred in the 1980s.

Figure 6. Income inequality in the lower halfRatio of income at the 50th percentile to income at the 10th percentile. Posttransfer-posttax income, adjusted for household size. Data sources: Luxembourg Income Study; OECD.

As figure 7 shows, the incomes of America’s poor have barely budged since the late 1970s. While middle-class incomes haven’t risen as rapidly as they could have given the country’s economic growth, they have risen. At the bottom, though, there has been only a minimal increase.

Figure 7. Household income at the median and at the tenth percentilePosttransfer-posttax household income. The incomes are adjusted for household size and then rescaled to reflect a three-person household, adjusted for inflation, and converted to US dollars using purchasing power parities. Data source: Luxembourg Income Study.

This also accounts for the difference between the United States and the other rich nations shown in figure 6. The US is one of the countries in which the absolute incomes of low-end households have risen the least during the past generation,6 and as figure 6 indicates, it is one of the few that experienced a rise in lower-half inequality.7 (The appendix has a separate graph for each country.)

HOW HAS GOVERNMENT RESPONDED?

Have government taxes and transfers become more redistributive in order to offset the rise in inequality of market incomes?8 Figure 8 shows the Gini coefficient (the most commonly-used measure of inequality, equal to 0 if everyone’s income is the same and 1 if a single household gets all the income9) for market income, for income after government transfers are added, and for income with transfers added and federal taxes subtracted. Transfers increased, so inequality of posttransfer-pretax income (the middle line) didn’t rise as much as inequality of pretransfer-pretax income (the top line). This happened mainly in the 1990s and in the 2000s, with the latter consisting largely of increases in spending on Medicare and Medicaid, which in these data are counted as transfers. Federal taxes became less redistributive, though only slightly so (figure 4 above), so we see little change in the distance between inequality of posttransfer-pretax income (middle line) and inequality of posttransfer-posttax income (bottom line).

On the whole, changes in taxes and transfers didn’t add to the rise in market inequality, but nor did they reduce it by much.

Our inequality statistics — Gini coefficient, share of income going to the top 1%, and others — are calculated based on households’ income in a single year. This misses the fact that people move up and down over time.10 Our incomes in any given year may be more dispersed now than several decades ago, but if many of us are switching places from year to year, why the fuss?

Two claims need to be distinguished here. One says there is enough movement up and down in the income distribution over time (in technical lingo, relative intragenerational income mobility11) that we needn’t worry about single-year inequality at all. It doesn’t matter whether inequality is high or low; it doesn’t matter whether it’s rising or falling. Single-year income inequality is simply irrelevant, on this view, because there is a lot of mobility. Since “a lot” and “enough” are in the eye of the beholder, evidence can’t confirm or refute this claim.

A second claim says that the rise in income inequality has been offset by a rise in mobility. Here we can look to the data for a verdict. Has income mobility increased?

For the bulk of the population — everyone but the richest — we have multiple sources of mobility data, including the Panel Study of Income Dynamics (PSID), the Survey of Income and Program Participation (SIPP), and earnings and income records from the Social Security Administration and the IRS. Studies using these data find that there has been no increase in income mobility in recent decades.12

What about at the top? A good bit of the past generation’s rise in inequality consists of growing separation between the rich, especially the top 1%, and the rest of America. Has this been accompanied by increased churn among those at the top? In 2007 the Treasury Department released a study based on analysis of tax records. It included data on movement out of the top 1% over two nine-year periods: 1987-1996 and 1996-2005. Single-year income inequality rose sharply during these two periods; the share of income going to the top 1% going to the top 1% of households jumped from 11% in 1987 to 14% in 1996 to 18% in 2005. But according to the Treasury study, mobility was unchanged. Of households in 1987’s top 1%, 62% were not in 1996’s top 1%. Of households in 1996’s top 1%, 60% were not in 2005’s top 1%. The large increase in income inequality has not been offset by a rise in mobility at the top.13

HAS CONSUMPTION INEQUALITY INCREASED TOO?

Yes, as best we can tell. Recent studies have used the Consumer Expenditure Survey (CEX) to compare trends in income inequality and consumption inequality since the late 1970s. The CEX isn’t designed to effectively capture spending among the top 1%, so it may overestimate or underestimate the degree to which consumption inequality has increased. The data, though, suggest that consumption inequality has increased almost as much as income inequality or the same amount.14

DOES INCORPORATING WEALTH ALTER THE INCOME INEQUALITY TREND?

Some believe we should incorporate wealth into the measure of income. Specifically, we should add an estimated income stream of, say, 5% of the value of people’s net worth. Would doing so change our conclusion about the trend in income inequality in recent decades?

Not much. Tim Smeeding and Jeffrey Thompson use data from the Survey of Consumer Finances (SCF) to calculate an income measure that combines standard income flows with imputed income to assets. Compared to the CBO income data (figures 4, 8), this measure suggests a higher level of inequality and a somewhat smaller but still sizeable rise in inequality.15

WHAT DO AMERICANS THINK?

Americans do appear to have noticed that income inequality has been rising, even before the Occupy Wall Street movement brought the issue to the forefront in 2011. But this has produced little or no increase in support for programs that directly address income inequality, for instance by increasing taxes on the well-off or by increasing transfers to the poor. Instead, the rise in inequality seems to have increased Americans’ support for programs perceived as boosting opportunity and economic security, such as education and health care.16

The expectation that government would respond in this way is based on the median-voter theorem. See Allan H. Meltzer and Scott F. Richard, “A Rational Theory of the Size of Government,” Journal of Political Economy, 1981.↩

Smeeding and Thompson, “Recent Trends in Income Inequality.” These data are available only from 1989 and they are pretax. Philip Armour, Richard V. Burkhauser, and Jeff Larrimore pursue a related approach (“Levels and Trends in United States Income and Its Distribution: A Crosswalk from Market Income Towards a Comprehensive Haig-Simons Income Approach,” Working Paper 19110, National Bureau of Economic Research, 2013). They count as income the (real or paper) change in a person’s net worth during the year. This yields the surprising conclusion that the top 1%’s income share in the US decreased between 1989 and 2007. However, this measure is likely to be very sensitive to fluctuations in stock values, which are the chief asset held by those in the top 1%. Hence the conclusion may be an artifact of the large increase in stock prices from 1988 to 1989 compared to that from 2006 to 2007. For more discussion, see Thomas B. Edsall, “What if We’re Looking at Inequality the Wrong Way?”, New York Times, June 26, 2013.↩